Bid-ask spread is typically calculated – as an absolute or in terms of percentage. This article explains the meaning of bid-ask spread and how you can calculate it, along with an example.
If you wish to create wealth by entering the investment markets, you’ll find innumerable opportunities to do so. However, the trick lies in employing the right strategies and sticking to a predetermined game plan. You have to accept that fluctuations are inherent to market trades. You must also acquaint yourself with various market jargons and terminologies and the different methods of calculations. This article explains what is bid-ask spread and how to calculate the bid-ask spread.
What is bid-ask spread?
In the financial market, the price at which an asset – stocks, funds, and other marketable securities, are sold is known as a bid. Conversely, the price at which investors are readily willing to purchase the asset is known as the ask. The difference between the bid and ask price is defined as the bid-ask spread. The smaller the difference between the two prices, the more liquid the underlying asset is said to be. Typically, investors prefer liquid assets since they tend to take a smaller financial hit, when they are both, bought and sold.
How to calculate the bid-ask spread?
Bid-ask spread may be calculated in two ways – as an absolute or in terms of percentage. In highly liquid markets, the spread values often tend to be quite small. Conversely, when the market is less liquid or even illiquid, the value of the spread value can be quite significant.
The following formulas are used to calculate the bid-ask spread
1. Bid-Ask Spread (absolute) = Ask/Offer Price – Bid/Buy Price
2. Bid-Ask Spread (percentage) = ((Ask/Offer Price- Bid/Buy Price) – Ask/Offer Price) X 100
Example to help understand bid-ask spread calculation
Let’s say a stock is trading at Rs. 9.50 or Rs. 10. As such, the bid price is Rs. 9.50, whereas the offer price is Rs. 10. In this case, the bid-ask spread is 0.50 paise, if considered on the absolute basis. If you consider the same example on a percentage basis, then the spread will be 0.50 paise or 0. 50 per cent.
Now let’s say you are a buyer and you procure the stock at Rs. 10 and then sell it immediately at the bid price of Rs. 9.50 – either purposely or by accident; you would incur a 0.50 per cent loss on the transaction value, as a result of this spread. Now, if you purchased and instantly sold 100 units of the stock, you would end up losing Rs. 50. However, if you bought and sold, 10,000 units, then the loss would be Rs. 5,000. In both cases, the percentage loss resulting due to the spread would be the same.
5 things you should know about the bid-ask spread
Having explained how to calculate the bid-ask spread, here are five things you should know about it.
1. The bid price is ideally the highest price that a buyer is willing to pay while buying securities
2. The asking price is typically the lowest price that a seller is willing to accept while selling securities
3. Traders often refer to the asking price as the “offer price”.
4. Trades are executed when the bid price overlaps the asking price
5. If a stock or fund is liquid, its bid-ask spread tends to be narrower. Conversely, if the liquidity of the stock or fund is low, the bid-ask spread widens.
Now that you know how to calculate bid-ask spread, you should also understand its significance, especially if you intend to become a regular trader. You can find out more about bid-spread here and also get in touch with an Angel One expert to know more.